“AMERICANS have watched austerity sweep Europe with a
certain Schadenfreude. But eight months from now
they may get a dose of the same medicine. The political
compromises that have produced much of America’s deficit of 8%
of GDP are programmed to go into reverse at the end of the
year, two months after the election. A stimulus package
consisting of a payroll-tax cut, investment tax credit and
enhanced unemployment insurance expires then, as do George W.
Bush’s tax cuts (which have already been extended by two years
from their original end-date of 2010). At the same time an
automatic, across-the-board cut in domestic and defence
spending, called a “sequester”, takes effect, cutting about
$100 billion from government spending next year.

The economic impact of this fiscal cliff is a matter of some
debate. The Congressional Budget Office reckons
that the combined effects of the sequester and the expiring tax
cuts would add up to 3.6% of GDP in fiscal 2013. But David
Greenlaw of Morgan Stanley, which puts the total
effect at almost $700 billion at an annual rate, argues that
the calendar-year impact is much larger, at around 5%. Others
think the effect would be smaller, noting that some people will
not experience the full tax hit until they file their returns
in 2014.

Even the lower estimates could easily be enough to tip the
economy back into recession. Mr Greenlaw says the closest
precedent was in 1968, when individual, corporate, excise and
payroll taxes collectively rose by the equivalent of 3.1% of
GDP, mostly to pay for the Vietnam war and to damp down
inflation. The next year, the economy fell into recession.”

It’s no secret by now that austerity has pulverized nations in a
balance sheet recession and that budget deficits have helped
sustain growth in others. So as we head into late 2012 and
2013 we should be keeping a close eye on developments here.
As I’ve previously noted, the balance sheet
recession effect is waning in the USA, but pulling the rug out
from under us in 2013 could be a colossal mistake….Stay tuned.